The slowdown lowdown: No cause for alarm

Another downturn is in the making it would seem, and all of a sudden we’re facing some pretty serious global headwinds. I don’t know if it’s a seasonal thing, but we always seem to have a bout of the downturns around this time of year. Sell in May or some such, right?

Fair to say that the equity price action may not reflect it so far – US stocks down only 2-3%. But it’s the question on everyone’s lips – where to from here? And the problem is that the mood is becoming very bearish. Certainly in the press, and a growing number of analysts – the usual suspects in many cases – are cueing up to talk things down.

Goldman’s is the latest to talk of a ‘summer slowing’, ‘spring break’ or ‘spring swoon’, but so far we are really only seeing it in the commodity price rout. Gold gets nearly all the attention here, but the fact is it isn’t just a gold story – copper is off 16%, silver is 34% lower and some of the soft commodities are down 10%-20%. This fact points to some broader malaise – the renewed slowdown push – and currently there are two fears. These are the ‘slowing’ in the US due to the government’s sequester program, and China’s economic slowdown, or conversely its property bubble, which is about to burst (people can’t make up their mind it seems).

I’m not going to spend a lot of time on China – readers should just note that talk of problems in China occur every year. While there is a lot of talk, these problems have never eventuated and there is no evidence to suggest China’s economy is slowing this time either – and the property bubble claim is tenuous at best (see chart 1). Even the International Monetary Fund, which has generally been on the more bearish side, expects Chinese GDP growth to average just over 8% over the next two years.

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The average since 1995 has been just over 9%, so we’re not talking about a major slowing. In fact, it’s a slight acceleration from what we saw in 2012. Putting it into Australian terms, that’s like growth slowing from 4% to about 3½%.

As to the US, the latest manifestation of alarm seems to be due to the sequester, and I take this a little more seriously. Alan Kohler mentioned this in his Weekend Briefing some weeks back (click here), and made reference to the fact that the bipartisan Congressional Budget Office (CBO) expects growth to slow substantially as a result of the sequester and jobs to be lost. There will be lots of jobs lost – 750,000 between March and the end of fiscal 2013 (which ends on September 30) to be exact.

As if on cue, the latest jobs report showed jobs falling to 88,000 in March (when the sequester started) after a 268,000 increase the month before – then we saw retail spending slow, alongside manufacturing. I’ll have to admit that the recent data flow does give credence to the idea the sequester will slow growth. And that’s after US GDP was barely positive in the fourth quarter of 2012.

There are, however, two reasons why I’m not worried by the sequester:

1. We are talking about very small sums of money and so,
2.  The estimated cost to jobs and growth is excessive – completely over the top in my opinion.

To see why, consider that on the CBO’s own estimates of spending cuts – not its growth and GDP forecasts – the sequester only reduces spending by $85 billion in 2013. Of that, the CBO reckons government outlays will fall by $42 billion for the rest of fiscal 2013 (and then $89 billion for fiscal 2014). Given that federal outlays are around the $3.5 trillion mark, this is an almost insignificant amount of money (1.2% of total annual outlays). Even considering the fact that the $42 billion is being crammed into the remaining nine months of the year (about $7 billion per month), this only amounts to a bit over 2% of the approximately $292 billion of monthly spending.

So we’re not talking huge sums of money here – especially considering the well-known waste by the something like 1,300 government departments and agencies. The US media reports that the Pentagon runs 234 golf courses, we see reports of private jets for high-ranking military officers, and subsidised housing. The, of course, there was widespread ridicule (and some concern) expressed over the Department of Homeland Securities’ decision to buy 1.6 billion rounds of ammunition – enough apparently for a 20-year civil war in the US (and some heavy armoured personal carriers). Another example comes from the centre for strategic studies, which estimates that over fiscal years 2012-13 $200 billion will be spent in Afghanistan alone.

With that in mind, especially with the waste noted above, I don’t find the arguments presented by the CBO and others that the sequestration will have a huge impact on the economy (see table 1) credible. In total, it expects a 1.2% cut in spending (2% for the six months to September) to cut GDP growth 0.6%pts (or 30%) to 1.4%. It also expects very soft employment growth – 1.26 million jobs to be created in 2013.

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Think of it this way. In a good year, the US might create 2 million jobs – so we’re talking about a 37% fall in the numbers of jobs that would have been created in a good year. We’re not in a good jobs year though, we’re in a great jobs year. On average, 2.3 million jobs have been created per year over the last couple of years (191,000 per month on average). That’s a big drop, and given that we’ve already seen 500,000 jobs created so far in the first three months of the year (just under 170,000 per month), for the CBO forecast to be correct, only 700,000 more jobs will be created this year over the next nine months. That means jobs growth would slow to 77,000 per month from the average so far of 170,000 – a 55% or 60% drop from the average of the last two years. And with an average growth profile like that, you can’t rule out some months where jobs growth falls to 40,000 or 50,000. Can you imagine the market reaction to that? The double-dip call would absolutely go out again and, I think it’s safe to say, this would ultimately lead to the end of the equity rally – a sizeable correction.

Do you see the problem though? To believe the story you have to believe in an enormous fiscal multiplier (the idea that a $1 government spending cut has more than a $1 effect through the economy). While many Wall Street economists might agree with the CBO, I think it defies logic and is completely unreasonable – especially given that the existence of fiscal multipliers isn’t even agreed upon by mainstream economists. Anyway, even if they do exist – a 2% cut in spending isn’t going to cut anywhere near like 60% of jobs per month.

No, the sequester cuts are effectively meaningless I think. For me, there is virtually no chance that the very modest cuts will lead to that much real economic turmoil. And September is still some time away. A deal could still be reached that would end the sequester (likely).

So I would argue, as I have in past years, that any action we see on markets is simply another opportunity to buy the dips. No need to rush in though. There is plenty of time to wait and see how things unfold.